Context
- The Finance Commission (FC) is constituted under the Constitution to distribute Union tax revenues between the Centre and States.
- It addresses vertical imbalance (between Centre and States) and horizontal imbalance (among States themselves).
- The 16th Finance Commission has retained the vertical devolution share of 41% for States and continued to emphasise equity as the guiding principle.
Concerns Raised By States
- Cesses and Surcharges exceed 15% of gross tax revenues but are not included in the divisible pool shared with States.
- States demanded that cesses and surcharges either be included in the divisible pool or capped at 8-10%.
- The Centre earns large non-tax revenues from natural resource extraction, asset monetisation and RBI surplus transfers but these are not shared with States.
- COVID-19 pandemic and GST structural changes have severely reduced the fiscal space available to States.
- Centrally Sponsored Schemes like MGNREGA now require States to bear 40% of programme costs, reducing their fiscal autonomy.
- Frequent changes in devolution criteria and weights across successive FCs make it difficult for States to predict their future revenue shares.
- Several States have demanded a higher vertical share of 50% due to mounting fiscal pressures.
The Growing Imbalance Between States
- The combined share of four major beneficiary States (Bihar, MP, UP, West Bengal including their bifurcated states) increased from 42.5% under the 6th FC to 51% under the 15th FC.
- The combined share of four southern States (AP, Karnataka, Kerala, Tamil Nadu including bifurcated states) declined from 24.8% to 15.8% during the same period.
- This widened the gap between beneficiary and contributor states to 35.2 percentage points.
- High fiscal transfers to poorer States have not eliminated disparities in basic public service delivery.
- In 2022-23, Bihar spent only Rs 937 per person on health while Arunachal Pradesh spent Rs 10,148 which is 10.8 times higher.
- Bihar’s per-student spending on elementary education in 2023-24 was Rs 20,282 compared to Sikkim’s Rs 1,30,498.
Key Recommendations Of The 16th Finance Commission
- Vertical Devolution: Retained the 41% vertical share for States and accepted the Centre’s argument that cesses and surcharges cannot be shared.
- Horizontal Devolution Criteria and Weights:
- The FC applied a square-root transformation to State GDP shares instead of using actual GSDP values. This reduced the advantage of economically stronger States significantly.
- Maharashtra’s actual GSDP share of 14.23% fell to 8.31% after transformation; Tamil Nadu fell from 9.09% to 6.67% and Karnataka from 8.95% to 6.59%.
- Revenue-deficit grants and sector-specific grants were abolished.
- States were directed to discontinue off-budget borrowings and maintain fiscal deficits below 3%.
| Criteria | Weight |
| Income Distance | 42.5% |
| Population | 17.5% |
| Area | 10% |
| Forest Cover | 10% |
| Demographic Performance | 10% |
| States’ Contribution to National GDP | 10% |
- Outcomes Of The 16th Fc Awards
- Overall devolution shares of 14 States rose marginally compared to the 15th FC.
- Karnataka gained the most (0.484 percentage point increase), followed by Kerala (0.457) and Gujarat (0.277).
- Tamil Nadu saw only a negligible rise from 4.079% to 4.097%.
- 14 States saw a decline with Madhya Pradesh experiencing the largest reduction of 0.503 percentage points.
- Southern States’ combined share has risen only slightly to about 17% while major beneficiary States’ share fell to just under 50%.
- The shift in favour of southern States is only about 1.2 percentage points which is marginal.
- The balance between equity and efficiency criteria shifted only slightly from 75:25 under 15th FC to 70:30 under 16th FC.
What Could Have Been Done Differently
- If the FC had assigned 25% weight to actual GDP contribution while reducing income distance weight to 27.5%, Karnataka’s share would have risen to 4.928%, Maharashtra’s to 7.218% and Tamil Nadu’s to 4.867%.
- Given total vertical transfers of Rs 104 lakh crore over the award period, even small percentage changes translate into enormous additional resources for States.
- A 2.392% increase in Maharashtra’s share would have translated into an additional Rs 49,744 crore annually.
Way Forward
- Future FCs should place greater emphasis on fiscal capacity and fiscal outcome indicators rather than relying predominantly on non-fiscal indicators like population and area.
- Principal Component Analysis method should be adopted for more data-driven and objective weight assignment.
- Cesses and surcharges should either be included in the divisible pool or capped to prevent erosion of the shareable tax base.
- Unconditional equalisation transfers should be linked to measurable outcome improvements in public service delivery to improve accountability.
- Delimitation after the 2027 Census may increase political influence of populous States, making it more important to insulate FC decisions from political pressures.
Conclusion
- Fiscal transfers alone have not ensured convergence in public service delivery between rich and poor States. Future Finance Commissions need to strike a better balance between equity for poorer States and efficiency incentives for better-performing States. A more transparent and data-driven approach to determining devolution criteria will strengthen cooperative federalism and ensure that all States are treated fairly.
